&quot;Private Equity Style&quot; for the Average Investor

Tim Courtney, CIO of Exencial Wealth Advisors, advises most clients against private equity investments; rather, he believes most investors would be better off leveraging small cap value funds to gain similar results. Here, he discusses the benefits of this strategy.

Tim Courtney: Great, great, thanks, and markets are doing well so that's making the day even better.

Steve Halpern: Could you give our listeners some background about your firm?

Tim Courtney: Sure, we are an independent registered investment advisory firm, and we manage about 1.6 billion in assets under management, and we have offices in Oklahoma City, Dallas, San Antonio, and Connecticut.

Steve Halpern: Now, you recently pointed out that a number of your clients have been asking you about investing in private equity, but you don't think that private equity is right for the average investor. Could you explain that to us?

Tim Courtney: Sure, sure. There are probably two or three primary reasons why we think that private equity generally shouldn't be utilized for most investors. One is it's illiquid.

One of the great advantages of public equity investing is that all throughout the day we see trades, even when markets are very volatile, we still see buyers and sellers getting matched up and trades being done in the public market, but not so in the private equity space.

It's very illiquid. You have whole times of instead of months or years that people might have for the average holding, for private equity you could go five years, seven years, or even longer potentially before you could sell.

Most people don't have that long of a timeframe at least in terms of holding a single position or being locked in.

Another reason is there's a lack of data out there. Unlike publicly traded securities, which would report in price very frequently, returns pricing data very hard to come by.

It's also very hard to come by when we do our internal studies on private equity and the returns that they've been able to generate.

We've heard stories about how some entities have been able to generate very good returns in the private equity space, but in terms of being able to go and verify this data on a broad market scale with all of the private equity deals that are being done out there, it's very difficult to verify that. There's a dearth of data.

Then finally, there have been some studies trying to determine what those returns have been, what should we expect in a private equity investment. It's illiquid and that's makes it riskier. You would think that the returns should by higher, but many studies have come out looking at specific private equity deals.

I think there was a study done at Harvard on this very issue and they found that the returns very often aren't matching maybe what some might expect out of a private equity deal.

Those are the three primary reasons I think: Illiquidity, lack of data, and some studies showing that the returns maybe haven't been what they maybe had been purported to have been.

Steve Halpern: Even though you're discouraging clients from pursuing these traditional private equity investments, you've developed another approach that may achieve similar goals without actually having to buy private equity deals. Could you explain this strategy?

Tim Courtney: Sure, sure. A lot of the private equity space has to do with going and buying a company that is trading at a substantial discount, and it's trading at a discount, it's trading at a low price for a reason, there's some kind of defect with the company.

Maybe it may be management problems, or maybe the marketing of the company hasn't been done properly. Maybe there's just some kind of unique risk involved in that company that makes it worth less.

The private equity firm will go buy this company at a relatively attractive price, a low price. They will then go fix it up and try to address that shortcoming and fix it. In addition, they'll use leverage, they'll borrow other people's money so that they don't have to use as much of their own.

Then the goal is to once it's been fixed up, almost like flipping a house, you've bought it at a discount, you've fixed it up, you used other people's money to buy the house, and now your goal is to sell it on the open market for a much higher price. That's a large part of what private equity markets are really attempting to do.

You can do that yourself using readily available tools that any investor has. You could go buy say a group of companies that have been beaten down, and a good proxy for this would be say small value companies.

You could go buy a US small value company index full of very similar companies that private equity firms are looking to buy out.

Then you could apply leverage to that small value index. You could use margin or other borrowing to lever up those returns.

Our studies have shown that generally speaking, private equity investments tend to be leveraged somewhere in the neighborhood of about 30% to 40% and you could replicate private equity returns by going and levering up a small value portfolio about 30% to 40% and get very similar returns if not better returns.

The advantage to doing it in this way would be you still have liquidity. At any time, you can still cash out this small value fund and pay back your margin.

You have complete control whereas obviously the private equity investments would still be illiquid.

We feel like you still get the expected returns of private equity, you're buying the same kind of strategies that they would, the volatility is very similar, but again, you're operating in a perfectly liquid environment where you can sell your stake at any time.

Steve Halpern: With that as background, could you walk us through what a portfolio would look like and highlight some of the specific investments that fit this mandate?

Tim Courtney: I think if you're wanting to do this in a way that it is attractive from a risk perspective, you would want to do this with hundreds of companies.

You wouldn't want to do this with just a handful of companies because when you're doing this you do have to recognize that you are buying some weaker companies.

That is part of what the private equity markets are doing, and they're operating in a space that have weak companies that have problems in them.

To diversify that risk away, you would want to do this with hundreds of companies, and therefore you're probably going to want to use something like an index fund or a mutual fund that owns hundreds of these small value companies to diversify that individual stock risk away.

Once you've chosen maybe a good proxy for a small value index, a Vanguard Small-Cap Value index or a lot of times we'll use the DFA Small Value Fund, you're going to get that exposure, that marketplace, and then inside of your account that you've bought, that small value index, you would want to apply an amount of leverage.

That's going to be, you don't have to necessarily apply leverage, but if you want to try and replicate that private equity return, you'll probably want to use somewhere in the neighborhood of around 30% leverage. That can be done through the margin capabilities of your brokerage account.

You would want to buy more of those small value companies, and then what we found is over the last 15 years or so doing this kind of strategy has given you returns that have been equal to, and in some cases maybe a little bit higher than the returns of the private equities that are available out there.

To do that, we go look at, to compare those returns, we go look at some private equity firms that are publicly listed and look at their returns.

We've found that they've very similar, and that anybody can get exposure to this kind of return just using the same kind of tools that anybody would have available to them in a traditional brokerage account.

Steve Halpern: Again, our guest is Tim Courtney, of Exencial Wealth Advisors. Thank you for your time today and for sharing a very interesting story. Thank you.